Transfer pricing refers to the way that related companies, such as a parent and its subsidiary, charge each other for goods, services, or IP provided to each other.

Transfer pricing is especially important when the transactions cross international borders. When business entities under common control engage in cross-border transactions, the prices they charge each other impact taxable income in each jurisdiction. As enterprises may otherwise be indifferent to where the profit lands, there’s an incentive to distort pricing in order to move taxable income to jurisdictions with lower tax rates.

Like other countries, the United States and the United Kingdom have adopted rules designed to prevent such price distortion.

In the US, the IRS has the power to adjust a company’s income and deductions if necessary to prevent tax evasion or to clearly reflect the income of each entity. See IRC § 482. To this end, the US has over 200 pages of regulations intended to ensure that transactions between related parties are priced as though the parties were dealing at arm’s length with an unrelated entity. See Treas. Reg. § 1.482-1 et seq.

Similarly, in the UK, where a transaction between “connected parties” occurs on terms other than those that would have been made between independent enterprises, HMRC has the power to calculate profits and losses for tax purposes as if the transaction had been conducted at arms-length. See Taxation (International and Other Provision) Act 2010, Section 147.

Unfortunately, US transfer pricing rules apply to all entities, regardless of size. In the UK, however, HMRC will generally not exercise this power where the “advantaged” entity is a small or medium-sized enterprise and the related entity is in the US. See Taxation (International and Other Provision) Act 2010, Section 166. Under Section 172 and applicable guidance, a small enterprise is one with 50 or fewer employees and either annual turnover or total assets of under £10 million. A medium-sized enterprise is one with 250 or fewer employees and either annual turnover of under £50 million or total assets of under £43 million.

Finally, Article 9 of the US-UK tax treaty provides that when a UK company and a US company are under common control and engage in commercial or financial relations that “differ from those that would be made between independent enterprises,” then each country can adjust the profits to the level that would have accrued had the relations been made on terms that independent enterprises would have adopted. When an adjustment to profits is made by one country, the tax treaty contemplates that the other country will make a reciprocal adjustment so that a taxpayer is not taxed twice on the same income.